Governance Reforms. The Big Three Index Funds contributed very few comments to the SEC and no amicus briefs over the past decade. They were much less involved than much smaller asset owners, such a public pensions and SRI funds.

Lead Plaintiff Positions. Big Three Index Funds refrained from taking lead plaintiff positions in any securities cases, even though they often have significant “skin in the game” compared to typical filers.

They advance policy measures to address incentive problems.

SEC could adopt a safe harbor that would allow fund families with a central stewardship unit to proportionately allocate such costs to all their portfolios.

Big Three Index Funds: Other Possibilities

Bebchuk and Hirst would rely primarily on government defined prescriptive behavior, rather than facilitating competitive market forces. While I support the goals of Strine and Bebchuk, timely implementation of their suggested reforms is unlikely. The SEC will not force big funds to vote in favor of shareholder proposals requiring a vote of shareholders before making political contributions or a mandate that corporations disclose such contributions, not while Donald Trump is President. Most of Bebchuk’s recommendations would likely be opposed by Big Funds, as well as corporate interests. Safe harbor provisions are more of a possibility but big funds have expressed no interest in such provisions, as far as I know.

When Leo Strine raises the issue of “forced capitalists,” he too acknowledges the powerlessness of investors to influence. His idea of requiring a super-majority vote to make political contributions address only one issue of many, although a very important one if democracy is to be safeguarded.

The National Association of Manufacturers, through their folksy sounding “Main Street Investor’s Coalition,” has also expressed concern over the helplessness of index investors to influence proxy voting. One of their solutions is the following: We will require that retail investors who own passive funds through 401(k)s, index funds and other vehicles have a say in how their shares are voted.

The Coalition may want retail investors to have more say because those investors typically have no access to data, reports and expertise used by institutional investor. Most actual retail shareholders do not vote. If they do, they vote as boards recommend. The Coalition is right, 401(k) plan contributors have no real voice. Additionally, most have little or no idea how their investments are voted or why. What exactly would “more say” look like?

John Wilcox of Morrow Sodali, a global consultancy and service provider with expertise in corporate governance, has an idea for more say. In his December 28, 2018 letter to the SEC regarding their Roundtable on the Proxy Process, he writes,

The concept of “pass-through voting” on matters relating to issuers has long been dismissed as impractical. It is not legally mandated because voting decisions for the silent majority are delegated to the fiduciaries who make investment decisions on their behalf. However, this hands-off approach is beginning to be questioned. In recent years stewardship codes have amplified the fiduciary standards that asset managers must meet in their oversight of portfolio companies, their governance policies and their proxy voting decisions. Even though there is currently no mandate for gathering feedback from the silent majority, the growing responsibilities of institutional investors and the availability of new technology are beginning to open the door to pass-through communications…

A case can be made that investors who delegate stock picking and proxy voting decisions to third-party professionals, while having no standing to vote at shareholder meetings, should have some means to voluntarily inform their fiduciaries about their views on issues affecting their investments. Indeed, both academics and regulators have recently raised questions about: (i) concentration and common ownership of stocks by index funds; and (ii) the exercise of voting power by ETFs without reference to the views of ultimate owners in managed accounts. These concerns combined with the growing popularity of collective investment vehicles will sooner or later give rise to private sector mechanisms for informal pass-through referendums on ETF’s and indexers’ voting policies. Pressure for such feedback mechanisms will surely increase as environmental and social concerns, shareholder activism and risk oversight feature more prominently in public discussions about corporate purpose and boardroom accountability.

For those ideas to work, investors should know how fiduciaries already vote on their behalf. Real-time proxy voting disclosure would provide stronger incentives for fund managers to vote proxies conscientiously. Real-time would probably be less expensive than submitting unsortable N-PX files because funds could open window to their voting platform, which already exists.

With real-time disclosure, proxy votes would get more attention from the press. Retail investors could benefit from the research and rationale behind announced votes and could provide better feedback to their funds. That feedback could inform not just proxy voting but marketing as well.

Indexes are starting to differentiate on sectors and a few even on activism. Witness State Street’s Fearless Girlcampaign and then voting against 400 directors in 2017 for lack of diversity. I will write more on these developments next week.

4 Responses to Big Three Index Funds: Bebchuk, Hirst and More

Excellent, timely and thought provoking. At what point are funds too big to discharge their fiduciary duties. In the Geopolitical context, Professor Paul Kennedy termed the saying “Imperial Overstretch” in explaining that an empire can extend itself beyond its ability to maintain or expand its commitments.

I think by derivation this may be applicable to index funds. But with an end to defined benefit plans being supplanted by defined contribution plans causing a tsunami of liquidity in the markets we have to work with the given to enhance investor stewardship-Indexing is Truly to Big to Fail!!

Agreed, they are certainly overstretched right now with respect to putting a paucity of resources into ESG analysis and proxy voting.

Yes, too big to fail in the sense that if they fail, so does the world’s economy.

There are enough big funds to create brands around ESG research and beliefs to create something like political parties. That might actually provide greater stability. Yes, these large funds are forever owners but those who invest in the funds are not. Even “forced capitalists” will look for options when they their fund disappoints. Once investors can see real market differentiation based on ESG and other factors, they are more likely to stick with a fund they believe in, especially one where they feel they have a voice, through thick and think.

Fiduciary Overstretch and apogee I believe as you note will lead to investor selectivity, fund retrenchment and ultimately over time better performance. The 21st Century Concert of Funds replacing the 19th Century Concert of Europe!!!